This is the second article in a two-part series on solar securitization. For additional background information on how securitization works, see part one.
When to securitize
In most cases, the parties who can securitize are likely to want to securitize their interests sooner rather than later in the term of the project. A developer will certainly want to monetize its rights as soon as possible to move on to other projects.
A tax equity investor who is using these transactions in part as a cash management tool will want to assure the CFO and the analysts that this non-core investment will not limit access to money required for the investment for a lengthy period of time, even if the tax benefit returns its investment below the line in a relatively short timeframe.
That being said, tax equity investors may be more cautious about doing so during the five-year recapture period for the tax credit in the event that the securitization is unexpectedly deemed to be a sale of the underlying property by the IRS, resulting in recapture of the tax benefits. Also, the transfer by a developer of its interest in a partnership flip could, if not structured properly, possibly result in a termination of the partnership for tax purposes, which can have a detrimental effect on the tax equity investor’s tax benefits. That should be a manageable risk if the securitization is done properly. However, tax equity may have a right to prevent the developer from transferring its ownership interest, in which case the only choice for the developer is to wait until it acquires the interest of the tax equity after the recapture period.
If a partnership between the developer and tax equity agrees to do a securitization at the partnership level, the developer may consider any effect of the disguised sale tax rules discussed in part one of this article with respect to its contribution of the receivables/PPA to the partnership. A transfer of the receivables to a partnership followed by a lump sum distribution of the proceeds of a securitization done within two years of formation would be presumed to be a taxable disguised sale.
The only portion of the distribution that would not be taxable would be an amount equal to the developer’s share of the liability created by the securitization -- if the securitization is otherwise treated as a nontaxable loan. Typically, that portion would be nominal, for example, equal to the 1 percent interest it has in profits and losses before the flip date. If instead the securitization occurs more than two years after the contribution by the developer, there would be no disguised sale if the securitization was not considered to have been contemplated initially.
If the developer is the lessor in a simple inverted lease, it could securitize its interest in most cases at any time during the term of the deal, in effect creating back-leverage.
How to securitize when tax equity approves a securitization
The primary issues that will concern a tax equity investor in connection with a securitization are likely to focus on unexpected tax consequences and security for any developer obligations. As discussed above, a tax equity investor will be concerned that the securitization does not jeopardize its tax credit during the five-year recapture period and does not otherwise create a deemed disposition of the asset. As in the case of other typical lease transactions, that risk should be manageable by ensuring that the securitization does not result in a monetization beyond the lease receivable. Primarily, that means that the securitization should not monetize the expected residual value or lessee purchase option exercise. In addition, in the transfer of rights to the special purpose vehicle (SPV) used for the securitization, the tax equity investor will not want to sell to that SPV the underlying rights in the hard assets generating the receivables; rather, a transfer of just the receivables is preferable. The banks may want the asset and the receivables separated into separate LLCs, but the LLC with the hard asset could remain with the tax equity investor and not the SPV.
With respect to a transfer of a partnership interest, the goal would be to ensure that the developer retains the indicia of a partner. At a minimum, the developer would need to retain all of the non-economic management roles for the partnership. Also, the tax equity party may have concerns if the developer securitizes its interest in the proceeds of a sale of the underlying property of the partnership as opposed to operating income, since it would leave the developer with no economic interest. Even if the securitization were treated as a loan for tax purposes, a 100 percent borrowing against the interest could be characterized as a sale of the interest since there then would be no equity interest.
In any structure that is subject to debt in place at the time of the securitization, that debt presumably will need to be repaid with the proceeds of the securitization given existing loan covenants. In essence, this could be viewed as a refinancing. In some cases, that might be done to achieve a better effective interest rate in a solar transaction, though there may be another incentive for a securitization. For tax economic substance purposes, the debt level in a solar securitization initially may be much less than the 80 percent to 85 percent seen in other types of equipment financings like those for aircraft.
If the securitization occurs an appropriate amount of time after the year in which the tax credit has been claimed, a tax equity investor may be able to increase the level of leverage in the transaction, that is, it may be possible to back-leverage it at a higher level more typical of other equipment financings. At that point, the investor would have had its equity at risk and would no longer be entitled to an additional tax credit. Tax advisers may want to consider the point in time at which the securitization to increase leverage is appropriate. Presumably, at the least, that would be at some point after the year in which the credit is allowed.
Tax equity investors in particular also may be concerned about the way in which the securitization is done in terms of whether the securitization is treated for tax purposes as a taxable sale of the receivable or merely as a nontaxable loan secured by the receivable. As discussed above, those considerations are essentially the same as those that historically have been faced by those wishing to securitize other types of receivables (e.g., by over-collateralization), and thus are not covered in this article in any depth. However, for the developer, taxable income treatment may not be a disadvantage if it has net operating losses.
Other considerations
In the securitization world, size matters. In most cases, it is not considered viable given transaction costs to securitize relatively small amounts of receivables. Solar transactions generally do not yet result in as large a receivable as some other traditional equipment financing transactions. Thus, it may be necessary for the parties to bundle deals to achieve a critical mass of revenue. Residential solar deals are typically done in tranches; in many cases, a tax equity investor will hold an interest in many tranches. It may be possible that the developer or tax equity investor could bundle all of its tranches if they feature similar credit-rating minimums for customers and thus achieve a critical mass. It may be that a developer could pool a number of its partnership interests to achieve a critical mass.
Since the application of securitization concepts to solar transactions is still in the developmental stage, we can anticipate further advances in structuring and perhaps additional hurdles once the rating agencies weigh in.
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Richard Mull is a principal in the Washington National Tax Group of KPMG, LLP, resident in the Los Angeles office. He has previously served as an attorney on the Joint Committee on Taxation, U.S. Congress, where he worked on energy credit, depreciation and leasing legislation, among other things.